Lost in the fracas over the Defense Department's futures exchange: It might have worked.July 30, 2003: 11:32 AM EDT
By Justin Lahart, CNN/Money Senior Writer

NEW YORK (CNN/Money) - Proponents of a Pentagon plan to create a futures market aimed at forecasting events could scarcely have predicted the brouhaha they would cause in Washington.

The Defense Department and the Bush Administration quickly stepped away from backing the project -- which would have allowed traders to speculate on the potential for terrorist attacks, assassinations and the like -- after the idea was branded as ludicrous and repugnant by Democratic lawmakers.

Deputy Defense Secretary Paul Wolfowitz reportedly went so far as to say it sounded like the Pentagon "got too imaginative."

In other words, the Pentagon's futures experiment is politically dead. Which is too bad, in a way, because it may have turned out to be a useful predictive tool. Or, to put it more bluntly, it could have saved lives.

Theoretically, futures markets are good at forecasting event outcomes first, because the traders active in them have access to far more information as a group than they do individually and, second, because new information can be quickly transmitted through the market, via price.

And because traders are using cash -- putting their money where their mouths are -- such markets aren't beholden to the same biases as polls.

A good track record

In practice the theory holds up well. Ever since 1988 the University of Iowa has run a futures exchange called the Iowa Electronic Markets, best known for its political futures markets, where traders bet on election results. In the past four presidential elections the market's election forecast was more accurate than polling data.

That said, the things that the political markets are trying to predict are far more benign than what the Pentagon was talking about.

In a press release Monday, Democratic Senators Ron Wyden and Byron Dorgan fretted that the Defense Department's plan to include thousands of anonymous traders in its market would create "the possibility that terrorists themselves could drive up the market for an event they are planning and profit from an attack, or even make false bets to mislead intelligence authorities."

The first example, where terrorists use the market to profit from attack, hardly seems like a serious problem. To begin with, like the Iowa Electronic Markets, the Pentagon's would be a small-scale market where even a big win would net only tiny profits. (Far better to wade into one of the major financial markets, which also trade off of major political events and where one would be far less likely to be traced after the fact.)

And if the market signaled that there was a higher probability of an event happening, there would actually less of a chance of it occurring, according to George Mason University economics professor Robin Hanson, one of the researchers involved in the Defense Department's futures market project. The reason is that terrorists would be giving up information that could curtail their chances of success.

"Giving money to gain information is exactly what we try to do in intelligence work," Hanson said. "If somebody wants us to pay a few tens of dollars to find out that there's a terrorist threat, so be it."

What of the situation where terrorists try to manipulate the market to mislead authorities? Hanson said that lab work shows when specific traders are given incentives to manipulate prices there is little effect.

Anecdotal information from the Iowa Electronics Market, where traders have appeared to try to influence results by betting heavily on a particular candidate (perhaps in a not-so-benign attempt to skew perceptions of who's leading) supports this notion.

"It has only a transitory effect on prices," said University of Iowa finance professor Thomas Rietz, "which daily trading soon swamps."

The other problem critics have with the Defense Department's futures exchange is that it was somehow morally repugnant for the government to set up a "casino" where people would speculate on things such as the likelihood of Yassar Arafat being assassinated.

Fair enough -- although Arafat might have found that information incredibly useful.

A better reason to scuttle the Pentagons's futures program is that private enterprise is already a step ahead of it. Dublin-based Tradesports' current events futures contracts have been steadily gaining attention ever since CNN/Money first highlighted its Saddam futures back in January.

In one of the current contracts, traders are speculating on whether weapons of mass destruction will be found in Iraq by the end of September. They're giving it just a 25 percent chance of happening.

It's a good example of how a futures market can convey information that Washington might not necessarily want to hear.